McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Management Accounting Lecture 8 (Chapter 3) Systems Design: Activity Based Costing

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Todays’ Lecture Shortcomings of Simple Job Order Costing What is Activity Based Costing? How is it Superior? How is it Applied? Journal Entries

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Shortcomings of Simple Job Order Costing Plant-wide allocation of costs may be a reasonable methodology for single product facilities Increasingly, companies produce a multitude of products out of the same plant These different products tend to consume different amounts of overhead Additionally overhead is increasing as a proportion of overall cost and consequently its allocation becomes more meaningful In these circumstances, a simple plant wide allocation is not granular enough to capture good product cost information

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. When cost systems were developed in the 1800s, the emphasis was on simplicity because: 1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. Assigning Overhead Costs to Products

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Plantwide Overhead Rate Plantwide Overhead Rate A single overhead rate used throughout an entire factory. Direct labor has often been used as the allocation base for overhead because: 1. Direct labor information was already being recorded. 2. Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated. Direct labor has often been used as the allocation base for overhead because: 1. Direct labor information was already being recorded. 2. Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1.Most companies sell a large variety of products that consume differing amounts of overhead. 2.As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor. 3.Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Today, direct labor may no longer be a satisfactory base for allocation of overhead. 1.Most companies sell a large variety of products that consume differing amounts of overhead. 2.As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor. 3.Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Plantwide Overhead Rate A plantwide overhead allocation system may not be optimal for many companies in today’s business environment.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Departmental Overhead Rates Finishing Department Shipping Department Painting Department Many companies have a system in which each department has its own overhead rate. The allocation base depends on the nature of the work performed in each department. In the machining department, overhead may be based on machine-hours, but in the assembly department, overhead may be based on labor-hours.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-base costing is required to account for these other factors. The departmental approach relies exclusively on volume-related allocation bases while some overhead costs may be caused by factors that are not related to the volume of production. Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs. Departmental Overhead Rates

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. A number of allocation bases are used for assigning costs to products. Activity-Based Costing (ABC)

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CostCost Activity-Based Costing (ABC) Consumption of Resources ActivitiesActivities Cost Objects (e.g., products and customers) Cost Objects (e.g., products and customers)

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity An event that causes the consumption of overhead resources Setting up machines Examples of Activities Admitting hospital patients Opening a bank account Billing customers Activity-Based Costing (ABC)

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity Cost Pool A “cost bucket” in which costs related to a particular activity are accumulated Activity Measure Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs Activity-Based Costing (ABC) Activity Rate A predetermined overhead rate for each activity cost pool.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Activity-Based Costing (ABC) For each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2. A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Designing an Activity-Based Costing System The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Related activities are frequently combined to reduce the amount of detail and record-keeping costs. An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured. For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling. Designing an Activity-Based Costing System

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Hierarchy of Activities

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Graphic Example of Activity-Based Costing Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment Various Manufacturing Overhead Costs

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Unit-Level Activity Batch-Level Activity Facility-Level Activity Product-Level Activity Graphic Example of Activity-Based Costing Labor Related Pool Machine Related Pool Setup Pool Production Order Pool General Factory Pool Parts Admin. Pool First-Stage Cost Assignment Various Manufacturing Overhead Costs Products $/DLH$/MH$/Setup$/Order$/MH $/Part Type Second-Stage Allocations

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Using Activity-Based Costing Comtek Sound, Inc.  Comtek Sound, Inc. makes two products: CD players and DVD players.  The company has been losing bids to supply CD players, its main product, to lower priced competitors.  The company has been winning all bids to supply DVD players, its secondary product.  Comtek Sound, Inc. makes two products: CD players and DVD players.  The company has been losing bids to supply CD players, its main product, to lower priced competitors.  The company has been winning all bids to supply DVD players, its secondary product.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Using Activity-Based Costing Comtek Sound, Inc.  For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units.  Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor hours.  Both products require two direct labor-hours to complete, for a total of 500,000 direct labor hours.  For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units.  Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor hours.  Both products require two direct labor-hours to complete, for a total of 500,000 direct labor hours.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Using Activity-Based Costing Comtek Sound, Inc.  Unit costs for materials and labor are:

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours: Predetermined overhead rate = $20 per DLH= $10,000, ,000 DLHs Direct Labor-Hours as a Base

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Direct Labor-Hours as a Base Since each product requires two hours of direct labor, $40 of overhead is assigned to each product.

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. The ABC project team at Comtek has developed the following basic information. Computing Activity Rates

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. We can calculate the following activity rates: Using the new activity rates, let’s assign overhead to the two products based upon expected activity. Computing Activity Rates

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Review Shortcomings of Simple Job Order Costing What is Activity Based Costing? When should it be Applied? How is it Superior? Journal Entries

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Tutorial Review of today’s lecture Questions A